Dividends Are Not Free Money

by Michael on Aug 26, 2013 · 11 comments

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The past few years have seen an explosion of interest in dividend investing. While there are (arguably) good reasons for this, many investors don’t seem to fully understand what dividend payments actually represent.

I thus thought it might be worth shedding some light on the subject. Note that my goal here is not to debate the merits of dividend investing, but rather to discuss where dividend payments come from and to point out why one of the most common arguments in favor of this strategy is misleading.

What is dividend investing?

For starters, what exactly is dividend investing? In short — and yes, I’m oversimplifying things a bit — it’s an investment strategy that involves building a portfolio consisting of companies with high dividend yields.

Why? Well, as noted above, there are a number of reasons for doing this. But one of the most frequent arguments in favor of dividend investing goes something like this:

Did you know that reinvested dividends accounted from XX% of the <whatever index’s> return from 19YY to 20ZZ?

You can fill in the blanks, but it’s usually a fairly large percentage of the returns of a well known index over a relatively long time period. Sounds compelling, doesn’t it?

Unfortunately, even if the numbers are accurate, such arguments can be rather misleading. Want to know why? Then please keep reading.

What are dividends?

Wikipedia defines dividends as follows:

A dividend is a payment made by a corporation to its shareholders, usually as a distribution of profits.

While dividends can technically be in the form of cash, stock, or property, the most common case is cash distributions — so that’s what we’ll focus on.

To pay or not to pay?

When a company makes a profit, it has a choice: reinvest that money in the underlying business or distribute it to shareholders. I guess they could also just hoard the cash, but we’ll ignore that possibility for now.

When they choose to pay a dividend, they reduce the amount of cash that the company has on hand. Thus, they reduce the inherent value of the company, and this is reflected in a proportional reduction in share value.

In other words, dividend payments are not free money. Rather, they represent a cashed out slice of the company’s value. And it should thus come as no surprise that it’s important to reinvest if you want your investment to grow.

Apples and oranges

This is not the same thing as saying that investments in companies that pay dividends will grow XX% faster than investments in companies that do not. But that’s what the argument highlighted above seems to imply.

With dividend payers, you’re getting a portion of your returns as cash — at the cost of a small hit to the underlying share value whenever these payments are made.

On the flip side, when a company chooses to reinvest in their operations, they are doing so with the expectation that they will be able to grow the business, and thus increase shareholder value. So they’re effectively doing the reinvesting for you.

In essence, failing to reinvest your dividends is akin to selling off a small portion of your holdings in a non-dividend payer and using the money for something else. We’re really talking about two sides of the same coin here.

The bottom line

In my view, what investors should really care about is the total return of their investments. That is, the growth in share value plus any dividends that are paid out (and, ideally, reinvested). How you get there is less important.

1 Jon @ MoneySmartGuides August 26, 2013 at 6:46 pm

Nice breakdown. There is no point in investing in a company just because it offers a dividend. You have to make sure that the company is a good company and is growing. The dividend is just the icing on the cake in my mind.

Plus, in this low-yield environment, some closed end funds are offering super high dividends. You think it’s great but in many cases, it’s just a return of capital, which isn’t a good thing.

2 Financial Independence August 27, 2013 at 9:48 am

The main reason I would consider investing solely for high dividends would be if I required a regular return which could be covered by the dividend payout – this would avoid the brokerage associated with having to regularly sell down your position but it’s a negligible difference.

At the end of the day, profits are either retained resulting in a higher stock price or they are distributed as dividends – you’re 100% correct that dividends aren’t ‘free money’. All you need to do is watch share prices drop by around the dividend price on the ex-dividend date.

3 Little House August 28, 2013 at 9:42 am

I’d have to agree that it doesn’t make sense to solely invest in a company because they offer dividend payments. Looking at the year over year return is a better way to gauge a company’s growth. Dividend payments can be looked at as just the icing on the cake if you’ve picked a solid company.

4 Michael August 28, 2013 at 9:50 am

Jon & LH: It’s not really icing on the cake if the dividend is offset against the share price. Really all that’s happening is that the company is choosing to make a taxable distribution of a portion of your investment.

FI: Yes, this is one of the aforementioned “good reasons” for holding dividend stocks. While they’re not guaranteed payments, many companies do whatever they can to continue making those payments in good times and bad. Thus, dividends can serve as a source of cash flow during down markets and help you avoid being forced to sell low.

5 Martin August 28, 2013 at 11:42 pm

I tend to disagree with you that the dividend lowers the value of the company once the dividend is paid. Saying that tends to look like a saying that dividends reduce ability of a company to use money in reinvesting back into the business. In my opinion both are misconceptions.

I read a study comparing two companies over long run. Both having plenty of cash available. (I think you would agree with me that having plenty of cash sitting on the company’s account doing nothing is a bad thing), so what the company can do? One of those companies decided to pay dividends, the other started acquisitions. Reckless acquisitions. The result? The company which paid the dividend was more careful with what they did with remaining money after they paid the dividends, the other went almost belly up and when it started paying the dividends to attract investors, the dividends weren’t sustainable and the company had to stop them. Who were those two companies? Johnson Controls and Lear.

As the dividend continues growing, the company’s price tends to grow with the same rate (see Johnson & Johnson as a great example). And why do we invest? To hope for a future increased value of the stock or to create a steady raising money machine which pays you your share as a thanks that you invested in it in the first place? After years of hoping for the first I decided for the second.

6 Michael August 29, 2013 at 8:11 am

Martin: Payment of a dividend quite literally reduces the value of the company. Once they make the payment, they have less money and nothing to show for it. This is a mathematical truism.

The question of whether or not a company makes judicious choices when reinvesting in their operations is a separate issue entirely. Yes, some companies make poor choices, but others don’t.

7 Martin August 29, 2013 at 10:05 am

I wouldn’t say it is reducing its value, it may just slow its growth. But in many cases it is dividends what make the company valuable.

8 Michael August 29, 2013 at 10:28 am

Martin: No, it literally reduces the value. On the ex-dividend date, they reduce the previous day’s closing share value to reflect the cash distribution. The same things happens with mutual funds in that their NAV goes down in proportion to the dividend distribution.

Related: Why Did My Mutual Fund Share Price Drop?

This isn’t to say that dividend investing is necessarily a bad idea. Rather, I’m simply pointing out that many people don’t fully understand what that dividend payment represents.

9 Martin August 29, 2013 at 9:27 pm

Michael, I still disagree with you. It doesn’t reduce the value of the company. It slows its growth or reduce earnings, but not overall value. To illustrate my point, let’s look at a company XYZ with a value index 100 at the beginning of the period (be it a quarter or year). Then the company makes 30 in earnings during that period. But it decided to pay 10 in dividends. it adds 20 to its value and the new index would be 120. Is this a reduction of value? Certainly not, it just grew less then if it added whole earnings to its new value. It would be reduction in value if the company made only 5 in earnings, but continued paying our 10 in dividends. The new index would then be 95 and such would be immediately followed by a dividend cut. As far as the drop of the NAV or stock price after the payout, you are still NOT losing any value at all. The drop is just compensation of the payout, but your account is not losing anything. If you hold that company in your account after the earnings your index in your account would be 130. The company pays you 10 in dividends. The price is reduced to compensate it, but your account still has 120 in company value and 10 in cash = still 130 as right after the earnings. And since you are an owner of the company (partial) no value overall was lost. The company just grew less after the payout.

10 Michael August 30, 2013 at 8:25 am

Hi Martin. You’re putting words in my mouth, and we’re essentially arguing the same thing. I never said that value will be lost overall. What I said (see the title) is that dividends aren’t free money.

The value of the company will be reduced. You admit yourself in your comment above (“the price will be reduced to compensate it”). But the overall value to the shareholder will be a push — other than the tax consequences of having the company pay a dividend vs. having retaining and reinvesting the profits directly.

To recap your example…

Company XYZ (originally valued at 100 units) accrues 30 units in profits. That 30 accumulates across the quarter and contributes to the underlying value of the company, meaning that the company is now worth 130 just prior to the dividend payment.

It then pays out 10, so it winds up with a share value of 120. Thus, the value of the company is reduced from 130 to 120, effectively offsetting the “gain” from the dividend. This is not to say that you (the investor) are losing money — and I never said you were.

In either case, whether the company pays a dividend or not, you end up with 130 in value (either 130 share value or 120 + 10). Hence my argument that dividends are not free money even though many investors and so-called experts treat them as such when singing the praises of dividend investing.

11 Steve September 4, 2013 at 8:37 pm

Michael and Martin,

A great and profitable discussion. I appreciate the civility with which you are carrying on the debate. It makes the content the focus which provides great education for the readers.

I think both of you are essentially correct but are simply looking at value from different perspectives. Martin seems to be assessing value in respect to a PAST benchmark such as a previous year or quarter. Michael seems to be assessing value in respect to a CURRENT benchmark which would be current value plus current earnings.

As far as accuracy in describing company growth in terms used in the financial world, Martin is correct. Growth in company value is typically measured as compared to previous quarters or previous years. If a company has earnings of $8 bil and decides to distribute $1 bil to shareholders as dividends then the company has ADDED $7 bil to its overall value over last year. The company has not actually lost value. It simply has not grown as much as it would have if it had not distributed the dividends.

Thanks for letting me chime in.

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